Unfortunately, they don’t, and traders struggle with “gap risk” and “jump to default risk” (in the credit markets) on a daily basis. One day an entity is solvent, the next day it’s not, and there may be little or no advance warning that things are about to shift from one state to the next.

That’s the key difference between textbooks on finance (which assume that things do trade in an orderly, continuous fashion) and real life, where things are messy and chaotic. Mathematician Benoit Mandelbrot started pointing this out 50 years ago, as we covered in a recent interview on the site, but mainstream finance theory continues to largely ignore what he says.

That’s why your redemption mechanism in an ETN, however good it sounds on paper, is not perfect and if the issuing institution gets into trouble, you may not be able to get out in time. Instead, you’ll end up as a creditor in the bankruptcy court along with everyone else, possibly facing a recovery of a few cents on the dollar.

For a real-life example of how quickly things can go sour, take a look at the performance of ETF Securities’ Agriculture ETC (LSE:AIGA) around the time of the Lehman bankruptcy and the near-collapse of AIG, which at that time was the firm guaranteeing payment of the ETC’s underlying index performance.

AIGA Price Data (Source: Bloomberg)

Date

Open

High

Low

Close

Volume

Friday 12 September 2008

7.78

7.97

7.78

7.8625

346,444

Monday 15 September 2008

7.885

7.89

6.72

7.70

1,043,849

Tuesday 16 September 2008

6.50

6.50

6.00

6.00

11,024

Wednesday 17 September 2008

-

-

-

-

-

Thursday 18 September 2008

-

-

-

-

-

Friday 19 September 2008

-

-

-

-

-

Monday 22 September 2008

7.18

7.55

7.18

7.4575

1,430,602

If you had held this ETC then you would probably have ended the week of Friday 12 September unaware that all hell was about to break loose. Lehman Brothers’ bankruptcy was announced early on Monday 15 September and markets immediately began to speculate that AIG would be the next domino to fall.

Although decent trading volumes were recorded in AIGA on the Monday, market makers stopped quoting two-way prices at some point that afternoon, as a press release from ETF Securities made clear at the time. According to one market maker, many clearing firms and prime brokers cut their credit lines to AIG that day, creating a discount in all AIG-backed debt products and drastically reducing liquidity.

In effect, if you didn’t get out on that Monday morning you would have been stuck with your position.

Some trading was reported the following day, albeit in very limited volumes and at a 20%-plus discount to the previous closing price. And remember, Bloomberg data record information provided by exchanges; anecdotally, in the over-the-counter market some trades in AIG-backed ETF Securities ETCs were conducted at a 90% discount at the peak of the panic.

Fortunately for investors, a Fed-sponsored bailout of AIG was announced on the evening of Tuesday 16September and, although it took a few days for ETC trading to get back up and running, AIG default risk had largely disappeared when the market reopened on Friday 19 September, by which time ETF Securities had also announced the introduction of a collateral mechanism to back up the ETCs.

One can quibble about the details here. There was no formal daily redemption mechanism (such as that which ETNs offer) for investors in ETCs, other than by trading with market intermediaries, for example. Equally, it wasn’t only certain ETNs and ETCs that got into trouble in late 2008 – many ETFs investing in corporate bonds also faced problems. And it wasn’t even just an ETF/ETC/ETN issue – the whole of the debt market was in turmoil at the time.

But there’s a central point to make about market liquidity, which, as one investor famously said, is there when you don’t need it but not when you do. The assumption that you can get out before the crowd if things go wrong is a dangerous one to make.